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Wednesday, March 14, 2018

Established Covered Calls Position in Alibaba Group Holding Ltd.

A new Covered Calls positions was established in Alibaba Group Holding Ltd. with an April 20th, 2018 options expiration date and at the $185.00 strike price when Alibaba was priced at $189.78. 

The Covered Calls Advisor considers Alibaba to be a core portfolio holding, so the current intention is to continue the pattern of prior months by establishing ongoing monthly Covered Calls positions in Alibaba.  With the March 16th expiration rapidly approaching and both current Alibaba Mar16th $180.00 Covered Calls likely to be assigned at expiration (an optimal result given that this outcome provides the maximum possible return-on-investment for these positions), an April position was established to ensure an ongoing Covered Calls position in Alibaba.  Alibaba's forecast is that revenue growth of about 55% will continue this quarter, in which case the trailing twelve months P/E ratio based on today's price would likely be about 37, high for most companies, but a good value given their ongoing growth potential.

As detailed below, a potential return-on-investment result is +3.0% absolute return in 39 days (equivalent to a +28.2% annualized return-on-investment).
The transactions and a potential result are detailed below:

1. Alibaba Group Holding Ltd. (BABA) -- New Covered Calls Position
The transactions were as follows:
03/13/2018 Bought 200 shares of Alibaba stock @ $189.78 per share 
03/13/2018 Sold 2 Alibaba April 20th, 2018 $185.00 Call options @ $10.22 per share
Note: this was a simultaneous Buy/Write transaction

A possible overall performance result (including commissions) would be as follows:
Covered Calls Cost Basis: $35,918.29
= ($189.78 - $10.22)* 200 shares + $6.29 commission

Net Profit Components:
(a) Options Income: +$2,044.00
= ($10.22* 200 shares)
(b) Dividend Income: +$0.00 
(c) Capital Appreciation (If BABA stock is above $185.00 strike price at April 20th expiration): -$960.95
= ($185.00 -$189.78)* 200 shares - $4.95 commission

Total Net Profit: +$1,083.05
= (+$2,044.00 options income +$0.00 dividend income -$960.95 capital appreciation)

Absolute Return: +3.0%
= +$1,083.05/$35,918.29
Equivalent Annualized Return: +28.2%
= (+$1,083.05/$35,918.29)*(365/39 days)

The downside 'breakeven price' at expiration is at $179.56 ($189.78 - $10.22), which is 5.4% below the current market price of $189.78.
A recent quantitative study titled "Which Index Options Should You Sell" provides statistically significant insights to determine which options strike price and expiration date combination should be selected to sell.  Figure 2 in this paper shows that the front month (i.e. next month) S&P 500 options in the range of -0.5 to -0.6 standard deviations on average provide a significantly better return than a basic buy-and-hold strategy.  For this Alibaba position, the $185.00 April 20th, 2018 monthly option was selected since its breakeven price is -0.5 standard deviations from the current price of $189.78.

Using the Black-Scholes Options Pricing Model, the probability of making a profit (if held until the April 20th, 2018 options expiration) for this Alibaba Covered Calls position is 62.8%, so the expected value annualized ROI of this investment (if held until expiration) is +17.7% (+28.2% * 62.8%), a nice result for this moderately in-the-money Covered Calls position, especially since there is no earnings report prior to the options expiration date.

The 'crossover price' at expiration is $195.22 = $189.78 + [$10.22 - ($189.78 - $185.00)].
This is the price at expiration above which it would have been more profitable to simply buy-and-hold Alibaba stock until the April 20th, 2018 options expiration date rather than establishing this Covered Calls position.

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